Are Debt Problems Lurking Below the Surface?

A screen displaying the Dow Jones industrial average after the close of trading on Thursday. When a long period of low interest rates ends, borrowers and lenders may retrench in ways that may not be initially obvious.

Brendan McDermid / Reuters

By PETER EAVIS

February 9, 2018

A decade ago, concerns that companies and individuals had borrowed too much money toppled the stock market from what was then its all-time high.

Now, with stocks again tumbling from record levels, are debt problems rumbling beneath the surface of what seems like a strong economy? The short answer is that, in most places in the world, the reckless borrowing that led up to the financial crisis of 2008 does not seem to have reoccurred. Still, when a long period of low interest rates ends, as appears to be the case now, all the borrowers and lenders who have grown used to cheap credit may retrench in ways that may not be initially obvious. In other words, debt has a propensity to bite the economy on the behind just when it least expects it.

Individuals look pretty good for now. Over the past decade since the housing crisis, many households have done much to repair their finances. Household debt is now equivalent to 51 percent of gross domestic product, down from 73 percent in 2008, according to Federal Reserve data. The sort of loose mortgage lending that contributed to the financial crisis has not returned, in large part because of new regulations that stop lenders from making loans that would be hard to repay.

But problems may be brewing. As my colleagues Jessica Silver-Greenberg and Stacy Cowley recently showed, credit card debt has been rising, burdening some borrowers. But this debt does not right now pose the sort of systemic threat that mortgages did a decade ago.

Something to watch: Check out the Fed’s special indicator for showing how much of people’s paychecks are being used to make payments on their borrowings. This is down a lot in recent years, but a prolonged rise could signal trouble.

Wall Street, for once, does not seem to be a pressing problem. Leverage is finance jargon for borrowing, and the big banks had a ton of leverage heading into the financial crisis. Banks get the money they use to make loans and trade from two main sources: They borrow it from depositors and creditors (who can demand their money back), or they get it from shareholders (who cannot demand repayment).

The more a bank relies on shareholder funds, or equity, the less leveraged it is. And, crucially, it is also at less risk of the sort of bank runs that threatened the global financial system in 2008. The good news is that banks are using a lot more equity these days. As the Fed noted after conducting stress tests of large lenders last year, banks had common equity capital, a metric regulators use to assess the strength of a lender’s balance sheet, that was equivalent to 12.5 percent of their assets, which was more than double the 5.5 percent they had at the start of 2009.

Something to watch: Regulators are thinking about loosening a regulation that limits leverage.

Companies may be the weak point. Corporations have gorged on debt since the financial crisis. Corporate bond issuance is up over $3.5 trillion, or 67 percent, since the end of 2007, according to calculations using data from the Securities Industry and Financial Markets Association, or Sifma. All other types of debt issuance, excluding United States Treasury debt, are either down or more or less flat over the period. Bank lending to companies and commercial real estate projects is up $1.2 trillion, or 40 percent, since the end of 2007, according to Fed data.

One of the reasons investors have kept buying corporate bonds is that, while some measurements of indebtedness flashed warnings, plenty of others did not. But there are signs that the binge had gone too far, even for these easy money times.

The yield on junk bonds, as measured by BofA Merrill Lynch’s high yield index, was close to historic lows last year, making the market vulnerable to any interest rate rises. What is more, in recent months the cost of corporate borrowing, on an inflation-adjusted basis, has sunk to what looks like an unsustainable low. In December, the yield on a bond rated Baa by Moody’s was 2.1 percent after subtracting the rate of inflation for that month. That figure was well below the average since 1950, but also significantly smaller than averages for the last five or 10 years.

Something to watch: Corporations may borrow less in coming months, which can have knock-on effects in the stock market and wider economy. When companies borrow less, they may have less money to spend on new investments or to buy back shares, an activity that has given support to stock prices. Track Sifma’s tally of corporate debt issuance, on a monthly basis, here.

What about the government deficit? Over the last 10 years, federal government debt has ballooned to over 100 percent of gross domestic product from around 60 percent. And the amount of outstanding Treasury debt has increased by roughly $10 trillion. Investors have been more than willing to buy Treasurys. But the recent tax cuts, which are expected to add to the deficit, and fears of inflation may lower demand for Treasurys, pushing up the borrowing costs for the government and others.

Something to watch: The yield on the 10-year Treasury note, which can be found here. On Friday, the note’s yield, which moves in the opposite direction to its price, was 2.81 percent, well up on 2.41 percent at the end of 2017.